Euro-clearing starts moving out of London

Deutsche Bank (DB) is moving 50% of its euro-clearing business from London to Frankfurt, the Financial Times reports.

The volume of London’s euro clearing market cannot be overstated, as it amounts to just under €800bn a day. The business is processing and clearing euro-denominated derivatives contracts by few and powerful clearinghouses, most prominently the LCR, of the London Stock Exchange (LSE).

The German lender is one of the five biggest clearers of interest rate derivatives in the City.

The move has broad significance for the financial sector, as it signals the beginning of a broader shift of business and jobs from London to the continent. A London Stock Exchange (LCH) report has estimated that the financial sector could lose 100,000 jobs in the Brexit process.

The UK hopes that Europe will “go global”

The Governor of the Bank of England, Mark Carney, has made the case that no European City can replace the role of London as a financial hub of global significance. However, most European cities looking to take a piece of London’s Euro-clearing business are content to acquire “regional” significance.

Speaking to Bloomberg on Monday, Carney advocated for an international road to deregulation, allowing London to continue to play a role in European finance.

“We can choose between a low road of protectionism focused on bilateral goods-trade balances and a high road of liberalization of global trade in services. The low road will cost jobs, growth, and stability. The high road can support a more inclusive and resilient globalization,” Carney said.

The systemic risk argument

The biggest volume of clearing transactions in the City is handled by the London Stock Exchange’s LCH. It should be recalled that on 01 June 2016 Deutsche Börse and the London Stock Exchange announced a merger, just days before the Brexit vote. Subsequently, in March 2017, the merger did not go through.

Officially, it was blocked by EU regulators, but the two institutions could also not agree on where they new institution would be headquartered. After Brexit, London is no longer the obvious answer.

Clearinghouses such as LCH or Deutsche Börse guarantee payments between parties to a deal so that the rest of the market is insulated by a default on payment. The sheer volume of the Euro-denominated market means the market poses a “systemic risk” to Europe’s financial stability, particularly after the 2008 experience.

Is this market grab?

The European Commission is not proposing to prohibit clearing in London as such. But, for clearing houses like LCH, the European Commission wants to ensure that ESMA and the ECB can vet and monitor their activity.

Given the volume of transactions, EU institutions should be able to determine the systemic risk they pose and take regulatory to mitigate it. Smaller clearing houses could theoretically continue to operate unhindered.

The problem with this argument is that in clearing scale and size matter. As a rule of thumb, the bigger the size of the clearinghouse, the greater the understanding of the market and the smaller the cost of the client.

Beginning with March 2019 – if there is no transition period – the ESMA could increase the cost of transactions with un-vetted clearinghouses it does not “recognize,” particularly those outside the EU. That would give Deutsche Börse a distinct advantage.

The systemic question is ‘who pays’ in case of a default.

First, if a major default were to happen, the ultimate systemic guarantor currently is the Bank of England. If that default happened in Frankfurt, the ultimate guarantor would be the European Central Bank.

Secondly, if a major default is triggered, as in 2010, EU institutions should have leverage over the risk-assessment of sovereign debt, keeping a lid in the self-fulfilling prophecy of surging margins.

Often, the Commission points to the fact that its proposals do little more than shadow similar vetting processes in commodity trading in the United States. In the City, this line of argumentation is seen as little more than protectionism.

They make a valid point, albeit a one-sided one. But, after Brexit, one-sided arguments could be the new norm as the City will have no major advocates in Brussels.